A few weeks ago the International Fund invested in a company that couldn’t even publish its accounts on time. The reason? Management couldn’t finalise its sales figure.
If management doesn’t know how their business is performing, what chance do we have? Complicating things further, this company operates in a niche market and its product is highly technical. Information about both is hard to find (spoiler alert: we’re not yet ready to disclose the name of the company).
Sometimes it is the complete lack of information that creates an investment opportunity. In this case, the company’s share price was down 85% in the space of a few months.
Less can be more
More research doesn’t always lead to better investment outcomes. There’s often a trade-off between the amount of research you can do and the return you can earn from mispricing. Markets are often efficient and mispricing can disappear quickly. By the time you understand all aspects of a company, it may no longer be available cheaply. Research gaps can be filled later and investments sold if contradictory information arises.
There are two keys to invest successfully when uncertainty is high. The first is the availability of an asymmetric payoff. The second is position sizing.
An asymmetric payoff means the prospect of large gains (multiples of your initial investment), and limited losses if things don’t go as planned. When such opportunities become available, investors shouldn’t focus only on collecting information. Acting fast can be what matters most. The asymmetry in the expected return is the opportunity.
When deciding to invest in this company, we acknowledged that if it can’t fix its problems, we may lose our entire investment. But we also collected enough information to suggest the business is facing only a temporary setback. Our research suggested that the product is real and that the business is growing. If this proves true, the investment has the potential to more than triple.
This way of thinking leads to another counter-intuitive reality of investing: the number of times you are right does not matter as much as how much money you make when you are right and how much you lose when you are wrong.
This is why position sizing is crucial. Portfolio weighting should reflect not only your level of conviction in an investment idea but also the risk of a severe loss. If portfolio allocation is wrong, a handful of large losses can quickly offset a long stretch of winners.
Investments that have the potential to yield outsized losses should attract a small portfolio weight. Our recent ‘sales-less’ investment fits this description and so it represented only 1% of the Fund.
Research shows that, psychologically, we suffer losses roughly twice as much as we enjoy similar-sized gains. In other words, we hate being wrong more than we like being right. That’s why many investors find it hard to allocate even a small part of their portfolio to a stock that may go to zero.
Yet if our goal is growing the value of a portfolio, we need to see past this natural ‘loss aversion’. After all, a 1% allocation to a stock that could go to zero has a risk profile that is identical to that of a 5% allocation where the downside estimate is 20%. In both cases the expected worst-case outcome is a loss of 1% of the portfolio.
In the past, we’ve enjoyed good success with small, asymmetric investments in stocks such as Whitehaven Coal, CST Mining and Odfjell Drilling. We’ve been bitten by a handful of them, too (Hughes Drilling and Dolphin Geophysical). But overall, they’ve added good value and we hope our new position will do the same.
Such investments aren’t the main game for Forager but we welcome them as an effective ingredient to spice up our returns when they present themselves.